Oil, natural gas markets brace for surprises

Crude's stimulus 'drugs' may wear out soon; supply's a drag for natural gas

TOKYO (MarketWatch) -- Energy traders certainly have their work cut out for them when it comes to guessing the next direction for oil and natural gas as the year comes to an end.

After all, oil's made an impressive run, poised to end the year with a gain of more than 75% after closing out last year down 54% -- its biggest yearly loss since oil futures started trading in New York.

And while natural-gas prices are about to end the year will little fanfare, around 4% higher for the year, that's still much better than the 25% loss they posted in 2008. Prices have more than doubled from their lows around $2.50 per million British thermal units in early September.

'These quantitative easing and zero interest rate drugs feel pretty good right now. The problem is that we cannot stay on these drugs forever.'
Phil Flynn, PFG Best

"For both the crude and natural gas markets, I would say look to sell rallies of false optimism, but be careful of surprises in the weather," said Todd Hultman, president of DailyFutures.com.

That's easier said than done since "false optimism" will be everywhere.

Still, most analysts agree that the outlook for both commodities look promising in the long-term big picture, with the near-term path likely to be a difficult one to travel as major economies around the world begin to exit their economic stimulus packages and raise interest rates.

"This year was one where many oil traders had to forget everything they believed about supply and demand ... and instead were forced to focus on the intricacies of currency exchange rates and global macro economics and the relationships therein," said Phil Flynn, vice president at futures trading firm PFG Best.

Oil had started the year in the "grips of a deflationary death spiral," he said. Prices hit a high above $147 per barrel in 2008, only to sink to lows near $30 by February of this year.

"As the [Federal Reserve] pumped in more cash, the dollar lost value and commodities soared and oil more than doubled in price," said Flynn.

"These quantitative easing and zero-interest rate drugs feel pretty good right now," he said. "The problem is that we cannot stay on these drugs forever."

Prying loose

Then again, a clean break may be just what oil needs, given that oil prices have been stuck in a relatively tight range around $70 to $80 for much of the second half of 2009.

The "removal of stimulus will be a bearish event for crude," said Flynn. "We will see the dollar rally and the fear that higher interest rates will slow demand should cause a major break in the price of oil."

But the low price oil should "create a buying binge," he said. "We should see sizable swings and opportunities similar to what we saw in 2009 [and] the price of oil at that point will be predominantly driven by improving demand."

Nearer term, the market should expect to see some price resistance between $70 and $82 per barrel, said Darin Newsom, a senior analyst at Telvent DTN. The "recent rally in crude has come with decreasing open interest and volume -- a classic sign of the last leg of an uptrend."

By the end of 2010, however, Patrick Kerr, a managing director at Amerifutures Commodities & Options, expects to see crude-oil prices to return to record levels and reach $150 per barrel, taking retail gasoline prices along with them -- to $5 per gallon.

"Prices of crude remain near $80 a barrel even as the U.S. and Europe remain in the worst recession since the Great Depression," said Kerr.

Oil's a "global market with no viable alternative and a finite quantity, [and] meets accelerating demand as 2 billion new people begin [to] keep pace with the developed nations of the world," he said, adding that Chinese demand for energy remains "massive" and alternative energy sources weren't seriously pursued during crude's price drop from the 2008 peak.

Bottom line is "look out for previous highs -- they will be surpassed soon and this time the price will likely stay above $100 from that point forward," said Kerr.

On the other hand, James Williams, an economist at WTRG Economics, provided a more mixed picture for the market.

"For the last two years I have noted the possibility of a very wide range in prices -- and 2010 could be another with prices as low as $40 or as high as $110 or even higher," he said.

On the upside, there are tensions building in major oil-producing countries. "Troubles with rebels and al Qaeda are spilling over into Saudi Arabia. Inflation, water shortage and unreliable electricity could lead to unrest in Venezuela and there is the ever-present problem of Iran's nuclear program," said Williams.

"Asian demand continues to grow and there's the potential for hurricane disruptions to output in the Gulf of Mexico in the New Year," he added.

But the U.S. and Europe are far from recovery, a double recession is a "distinct possibility," oil producers have more spare oil production capacity and there's the threat of fuel switching and technology to make oil more energy efficient, Williams said.

Bridging the gap

Against that backdrop, natural gas has the chance to play a more important part as an alternative fuel. Whether it takes that opportunity is another story.

Kerr points out that since crude's record high of around $147 in 2008, natural gas has "stepped into the picture as a 'bridge fuel' -- the bridge between crude oil and alternative energy solutions, [so] as crude becomes more valuable, so does natural gas."

And recently, the contango in the futures spreads for natural gas, a situation where the distant delivery prices for a commodity is above the spot price, has "all but evaporated, indicating solid seasonal buying" in the market, said Newsom.

He sees $6.13 per million British thermal units as the next target price for natural gas, with the next target at just above $8.

But, as many would agree, the natural gas market will probably have to get past its big supply surplus first.

U.S. supplies are ample, with stocks in storage up 12% from the same time a year ago, as of the week ended Dec. 18, and the Energy Department predicts that inventories of the commodity may see the highest end-of-winter storage level since 1991.

The government also expects a 1.9% fall in 2009 natural gas consumption along with a production increase for the year of 3.7%.

"That doesn't sound very bullish to me," said DailyFutures.com's Hultman.

Michael Lynch, president of Strategic Energy & Economic Research, said he doesn't think the odds are good for significantly higher gas prices in the coming year. Natural gas is "tricky" and "much more driven by weather ... and industrial activity" than oil.

In the end, though, "while gas probably won't go up too far, it doesn't have as far to fall as oil," said Williams.

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